How to manage your employee stock options

So, given the contractual terms that apply to ESOs and some additional restrictions that officers and directors have from SEC rules, managing the positions efficiently is not a simple matter. That said, the vast majority of the millions who have ESOs have no idea of the value of their holdings, the risks of losing that value or how to manage their options. They generally are advised by wealth managers and advisers who believe the only way to manage those positions is to make premature exercises after vesting, sell the stock and invest the residual proceeds into a mutual fund or some other structured investment.

But along with this strategy comes two major penalties to the exercising grantee: 1) A forfeiture of the remaining time value, or time premium, in the options, and 2) the penalty of an early tax payment. The consequences of these penalties can be significant (see "Costs of exercising," below).

Both graphs assume an "expected time to expiration" rather than maximum contractual expiration. Both illustrate the time premium, or time value, that is forfeited on premature exercise, the approximate tax that becomes due, and the residual proceeds available for re-investment. The essential difference in the two graphs is the assumed volatility that is necessary to calculate the time value of the options. The second graph assumes 0.60 vs. 0.30 in the first. This causes substantially different time premiums.

Both graphs show the same tax payable upon exercise. There is a cost associated with paying the early tax that can be calculated using an expected return on invested funds of perhaps 5% annually.

As can be seen, there is a large amount of lost ESO value and tax liability when premature exercises occur. If a stock has a 0.30 volatility and is 100% above the exercise price of the ESOs having 4.5 expected years to expiration, the forfeited time premium equals about 39% of the take-home amount. With the higher volatility of 0.60, the forfeited time premium equals 53% of the take-home amount. Those percentages substantially are larger when the stock is less than 100% above the exercise price when exercise occurs.